in fnews.yahoo.com :
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Last week I noticed that K2 (NYSE:KTO - news) had been pummeled on
news that its Q3 earnings would not meet expectations. Among other
problems, the company's press release pointed out that its bike group was
having problems as "the high end of the full-suspension market declined
rapidly." Due to the widespread nature of the problems, I decided not to
delve further into K2 at this time.
The day after the K2 warning, I saw a headline that caught my eye:
"Cannondale Corporation (Nasdaq:BIKE - news) Announces
Increased Revenue and Earnings." This bicycle maker crossed my radar
last March when it issued an earnings warning of its own (and fell
around 25% in one day). I snooped around at the time, but didn't look into
it further until this week. Heck, a company growing earnings and
revenue while its competitors are not sounds worthy of further
investigation to me. A quick check of the Fool website snapshot and
estimates indicated that Cannondale is trading at 0.9x book value, has
anticipated earnings growth of 17%, and carries a P/E ratio on fiscal
1999 estimates (ending in June) of 10x. Those attractive valuation
statistics piqued my interest even more.
The first line of Cannondale's most recent 10-K states that it is one of the
leading makers of high-performance bicycles. Hey, isn't that the same
market segment in which K2 is suffering? How is that happening?
Cannondale has significant international exposure, with 51% of its fiscal
1998 sales coming from abroad. About 90% of these sales come from
Europe, with the remaining portion coming from Japan and Australia.
During 1998, the company experienced 16% sales growth in Europe
while U.S. sales were down slightly. Gross margins fell to 35.8% from
37.6% due to adverse currency moves and an unfavorable product mix
in the U.S. It looks like the company is doing fairly well because it is
focused on the European market, which is stronger than the domestic
one. This hypothesis is supported by the fact that K2 has much less
international exposure than Cannondale.
Beyond weaker margins, why did Cannondale's EPS fall from $1.51 in
1997 to $1.08 in 1998? A big portion of the decrease is related to increased
spending on research and development (R&D), which jumped from $3.6
million to $6.8 million during the period. It turns out that beyond normal
R&D for bicycles, the company is working on developing motocross
motorcycles. The company believes that this product line will build on its
core competencies of aluminum frame fabrication, Headshok needle
bearing suspension, and short-development cycles. The product line
should be introduced in the summer of 1999. My initial reaction to this
move is that while Cannondale might have the manufacturing prowess,
motorcycles have a completely different distribution channel that the
company will need to conquer. Nonetheless, only time will tell if this
investment proves to be a worthwhile product expansion or a value
destroying di-worsification.
I have decided to hold off on making an investment decision on
Cannondale. Characteristics such as the company's respected brand, its
seemingly attractive fundamental valuation, and improving Q1 results
are appealing. On the other hand, the first quarter is a small portion of
the company's full year earnings (less than 10%). I want to see the
year-on-year profit improvement continue into the more important
later quarters of its fiscal year.
Another concern is that the company's inventory is increasing more
than sales. The $39 million inventory level at the end of June was up 30%
from the year earlier level, while sales increased 6%. Without some
stabilization of inventory growth, the company might find it necessary to
make one of those painful write-offs of obsolete stuff. Finally, I need to
learn more about the motorcycle move. Is this going to rev up growth or
cause a crash and burn? Despite not taking action now, I have socked
away some information about the company and will be prepared to take
action down the road if my questions and concerns are satisfactorily
answered.
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